Vincent Raymond Reinhart
Chief U.S. Economist, Morgan Stanley; Visiting Scholar, American Enterprise Institute for Public Policy Research; Former Director, Division of Monetary Affairs, Board of Governors of the Federal Reserve System

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SEBASTIAN MALLABY: Vincent was a little bit slow getting on the stage because of his Davos boots. (Laughter.) I refer to Davos as "CFR Lite." (Laughter.) It's much better to be here.

For those of you who don't know me, I'm Sebastian Mallaby. I work here at the Council on Foreign Relations. We're going to do the "World Economic Update." We've got Kathy Bostjancic from The Conference Board. We've got Lewis Alexander, chief U.S. economist for Nomura. And the man who's going to Davos is Vincent Reinhart, chief U.S. economist for Morgan Stanley.

We've got a couple of housekeeping points, which is don't use those things that go beep and vibrate because they mess up the sound system. There is an overflow room for those of you who want to use your devices. And secondly, this is on the record, not off the record.

So I'd say that relative to last time we had one of these meetings, there is, I think, a slight greater sense of optimism in the world economy. And I want to try and sort of tease out which of that is real or what's fluff, what's not going to last.

So I want to divide it out by saying, first of all, to Kathy, if you imagined for a second that "Planet Washington" kind of floated off into the stratosphere and you could analyze the U.S. economy in the absence of policy uncertainty, like just the business cycle, what's going to happen with housing starts, do you feel we're at a turning point in the cycle? Would the U.S. -- would the U.S. outlook be significantly stronger than the 2 percent standard predictions if you could take policy and politics out of the picture?

KATHY BOSTJANCIC: Well, first of all, I just want to say good morning, everyone. Thank you for coming.

And that's a great question, Sebastian. I guess without getting -- you know, pontificating on that, if that's in actuality or how we would all feel about that -- and I think the reality is the underlying fundamentals of the U.S. economy are getting stronger.

You know, from our viewpoint at The Conference Board, we can see this from various measures and particularly, as you mentioned, housing. I mean, housing is the great locomotive for the U.S. economy. And we produce something called the Leading Economic Index, which probably many of you are familiar with. And one of the 10 subcomponents is building permits, which obviously is a reflection of the housing sector. And that's the one area that's been greatly lagging behind, as we know. And we can clearly see that. We know that. But you could also see it when we plot the underlying components.

And typically, housing is not just a leading indicator but one of the earliest. The yield curve is probably the single earliest measure, the difference between the 10-year Treasury note and fed funds rate. But building permits is right behind, and it's obviously lagging.

So if we get that to turn, and indeed, it does look like it's strengthening, that could be a big game changer. Now, doesn't necessarily mean that we, you know, accelerate to 3 (percent), 3 1/2 percent, but certainly you could see a moderate strengthening to 2 1/2 percent.

So I guess our view right now is aside from the fiscal drag and all the shenanigans related -- you know, we go from the cliff to the ceiling debate -- that probably growth could be around 2 1/2 percent. And as the housing sector grows as a share of the economy, becomes even more powerful.

And also, it contributes both directly and indirectly to the -- to the U.S. economy. It creates jobs and then all the ancillary businesses. So some numbers that we've worked with is that once housing is -- this year-on-year pace of housing starts about 30 (percent), 35 percent continues, the improvement, you could start to see an additional 50(,000) to 60,000 payroll jobs created over time, which is quite significant.

MALLABY: So Lewis, now let's bring Washington into the picture with this question. How much do you think -- and I know you've studied this a bit -- how much does the uncertainty coming out of Washington actually affect output?

ALEXANDER: I think you could make a pretty good case that it is important. If you look just what's happened over the last year, we had a big slowdown in investment last year sort of around the middle of the year, and I think that was related to uncertainty around the election and certainly around the outlook more broadly and, in particular, the fiscal issues.

We've done a bunch of work on this, you know, econometrics, and I sort of convinced myself that this is kind of a real thing. And we think that it's been very important, oh, you know, really starting last year. And as we think about it going forward, we think it's going to be important as well.

We're obviously at a point now where there's a lot of uncertainty about, in particular, what's going to happen with fiscal policy, but there's really the broader issue of policy going forward. Our basic view is we think we're going to kind of get the fiscal stuff behind us and have a better second half, in part for the reasons that were just mentioned.

But it does depend on the notion that you can actually have some positive developments in policy beyond just the fiscal debate. So for example, one of the things I'm watching very closely is whether or not we've got a realistic prospect of tax reform. I think this is a very important issue. We desperately need it. I think there was a lot of work done on it last year that sort of laid the groundwork for this. I think under the right circumstances you could have that, and that would be a very positive thing, but it does depend on how the politics evolve. And as I sit here today, I'm less confident of that than I would have been, say (a month ?) ago.

MALLABY: When you say tax reform, what do you -- what do you mean? Which aspect?

ALEXANDER: So I -- we do sort of broad, fundamental tax reform in the United States about once every 25 years. Last time we did it was '86. It's kind of long overdue. You had -- the president had a working group that came out advocating essentially a revenue-neutral corporate tax reform last year. You had the House Ways and Means Committee doing a bunch of hearings that were also aimed at that.

Look, we -- our tax system just becomes more and more complex and more and more dysfunctional over time, and we need, every now and again, a general, broaden-the-base, lower-the-rate kind of approach, and I think that's what we're on track for. If we could get that as a consequence of these things, that would be a very positive thing.

There are other issues as well. There are things we need to do on energy. Immigration is another thing which has an important economic effect, so I think the --

MALLABY: But longer run, in the case of -- right?

ALEXANDER: Yeah, absolutely. So I think the broader question of how functional is the policy environment matters in the first instance in terms of what's going to happen with taxes and spending and all of that, but also this broader question of can we actually make progress in some of these things. I continue to be cautiously optimistic, but that is going to depend on -- very much on how kind of Washington evolves.

MALLABY: So Kathy is saying that there's underlying potential in the housing sector. You're saying that corporate investment -- that all that cash sitting on the balance sheets could start to be deployed if you could get the uncertainty down.

ALEXANDER: Mmm hmm. (Affirmative.)

MALLABY: Let me ask Vince and then maybe (Walter ?) to comment on Washington. Do you think that it's going to happen? Is there going to be enough of a deal? We reached the end of the screech point, didn't fall off the cliff. We've just had another breakthrough, apparently, today, if the House passes the measure. Will we get through the sequester as well?

VINCENT REINHART: I think the right characterization is that politicians are getting in the way of the expression of the resilience of a market economy. The financial crisis is further and further in our rearview mirror. Some of the level adjustments have been done, and that means a lessening drag on economic activity.

I think, however, that there are considerable downside risk associated with the political process. Only in Washington would it be considered progress to have one crisis event, the fiscal cliff, transformed into three separate events -- (laughter) -- the sequester on March 1st, the debt ceiling on or about March 1st, and then the lapsing of the continuing resolution on March 27th.

I don't take the news out of Washington as a sudden outbreak of harmony. I think rather it's House Republicans have settled on a strategy, which is fight a one-front war; seem reasonable on the debt ceiling by having a clean, temporary extension; let sequestration kick in, making the argument it's terrible spending restraint, it is poor -- poorly designed, but spending restraint is so important we're going to let it happen; and then rest everything on the budget and say, the Senate hasn't passed a budget in four years, the president isn't leading in this particular way; if we can't have a budget, then the government deserves to shut down.

MALLABY: Kathy, your Conference Board is constant touch with the big corporate -- do you agree with Lewis that you can actually foresee how investment plans are being put on ice because of this uncertainty?

BOSTJANCIC: Oh, sure, absolutely. I mean, we see it in the hard data. You see it in the orders and the shipments data foremost. You saw that starting to collapse in the third quarter. And some good news is it rebounded a little bit in the fourth quarter.

But in terms of sentiment, we survey CEOs -- again, measure their CEO confidence -- and it definitely deteriorated leading up to the fiscal cliff uncertainty.

And I would note if you look back in, you know, third -- the summer of 2011, you also saw a sharp deterioration in our consumer confidence and our CEO confidence. So -- in fact there was a very steep drop in consumer expectations.

This time around consumer expectations faltered a little bit ahead of the fiscal cliff, but the question is what happens, you know, as Vince laid out, over the next several months here, as -- because we have three fiscal hurdles to get through. So that could be really batter confidence at the CEO level and consumers'. So even though they have all this cash and would love to spend it, I think the fact is the uncertainty hasn't been really removed. That's the problem.

MALLABY: Do you think that if there is -- is the source of the uncertainty -- to fix that, do you need simply to get through these various cliffs and so forth, or do you actually need to do proper reform? Would the first be enough?

BOSTJANCIC: Oh, I think the first -- well, maybe Lewis would comment on that, but I guess my comment would be the first would be good -- first step, but obviously we would want more than that.

ALEXANDER: Just let me respond. I mean, first of all, to your direct question, I think you do need both. I mean, obviously the fiscal stuff matters in a --

MALLABY: (Or you'd rather not say, but ?) --

ALEXANDER: -- you know, very direct sense.

MALLABY: Right.

ALEXANDER: But from my sort of more optimistic outlook, sort of starting in the second half going forward, I need some prospect of real reform on these other issues. And if all we do is get resolution of the fiscal stuff without those broader issues, I'm going to be less optimistic going forward.

I'd like to nuance a little bit what Vince said. I mean, in some sense I broadly agree with it, but I do think this moving of the debt limit to the end of the queue rather than the beginning of the queue does -- is a positive thing in the following sense. I think the prospect that you were going to play chicken with the debt limit created a set of risks that were frankly very problematic. And the fact that we have at least sort of moved that to the end of the process, not the beginning, is a material mitigation of the potential distribution of bad outcomes relative to what it was before.

Now I totally agree that it's -- you know, one cannot describe the U.S. process as a particularly sensible one, and Lord knows there are lots of risks along the way.

But I do think, relative to at various points over the last several months when you've thought about how this might play out, you know, sort of, we did a tax deal that avoided the worst elements of fiscal contraction that were, you know, sort of in the law. We've now kind of moved the debt limit to a place where it is less prominent in this process. You know, ultimately there is the longer-run question of can we bridge the gap between the two sides and actually make some real progress on long-term fiscal consolidation. You know, that remains very much in doubt. But it does seem to me, relative to the distribution of potential risks of where we were in sort of mid-December, we're at a better place.

MALLABY: Vincent, Larry Summers had an interesting piece in the FT yesterday or today where he argued basically that if, you know, you -- certain types of spending cut actually are going to expand the budget deficit because it's kind of a fake cut, doesn't do -- represses spending, which will then splurge up later. So for example, if you just cut by not doing any maintenance on your infrastructure, that'll cost you more in the long run. Do you think that there's -- that kind of perverse outcome is a significant risk, that all the politics around deficit reduction actually winds up making it worse?

REINHART: Oh, in a couple ways. And you see historically, countries with very high debt loads tend to grow more slowly. Why? Well, two important reasons are -- number one is you walk away from positive net present value projects. That is, think about how much infrastructure rebuilding we would be talking about after Hurricane Sandy or the tsunami in Japan if both countries had lower levels of debt. Second, you are less effective with discretionary stabilizer because you -- you know, we are talking about fiscal consolidation with an unemployment rate near 8 percent. So I think those are the -- among the reasons you grow more slowly, and it is consequential.

Now, what do we have to do? Republicans have to recognize you have to raise the average tax rate, and Democrats have to recognize the most efficient way of raising the average tax rate isn't in our -- adding to our already complicated system with opaque, baroque and just odd sets of marginal rates and tax expenditures.

So is there an opportunity? Yeah. The good news is we are extremely far inside the efficient frontier for delivering fiscal policy. That's good news --

MALLABY: That's an economist's way of saying it's rubbish.

REINHART: Because it's good news is -- there's no one set direction you have to go. We could have a national conversation on issues of fairness, progressivity, you know, the safety net. Will we have that conversation? Don't think so. And so will we get the two parts that Lewis expects for us to launch into a higher growth trajectory? Not obvious. Will we resolve the near-term fiscal risks? Well, we have to. But does that mean it will be relatively seamless? No, I think the odds of a government shutdown could be -- are pretty high.

MALLABY: I mean, that raises the question, which maybe Kathy could address first, but others might want to chime in, as to whether -- I mean, you know, to what extent are we talking about a kind of -- a big rethink of the social contract? You know, taxes could wind up being significantly higher. Something deep and serious could be done about entitlements. I mean, that's what's on the table. Whether we deliver it now or in a few years, who knows. But do you think the business community is psychologically prepared for that? Do they welcome that? Do they -- how do they feel about it?

BOSTJANCIC: You know, I think that the business leaders would welcome it. I think they want to see a serious discussion on the fiscal issues when you look out. You know, we know that the spending side of the equation has been problematic for decades. I mean, you just had to look at the -- you know, the demographics of that. So clearly, the entitlement spending is unsustainable.

And then if you look at -- you know, even if you look where revenue is now as a share of GDP, it's running, you know, 15 (percent), 16 percent. It should be -- you know, historically is around 18 percent or so, maybe a bit higher. And spending is also typically around 21 percent of GDP, and we've been running, you know, well north of that. It slowed down recently, and we will -- we will see some correction in the deficit just as the economy is strengthening and also we wind down some of the expenses related to foreign wars.

But that entitlement spending -- because what you could see if you look at the projections, you get the dip in the deficit, and then it starts to go higher. So clearly, I think, that's a problem, and I think the business community would love to see some real debate and action on that front.

MALLABY: So in light of all this -- do you want to -- no -- so in light of all this, maybe, Vincent, is monetary policy appropriately supportive, given all this continuing uncertainty or is it actually adding to the uncertainty by being too experimental?

REINHART: Well, Federal Reserve policy's a work in progress, and in terms of providing accommodation, the reassurance that the policy rate will stay at 0 for a very long time is important. The expansion of the Federal Reserve balance sheet provides extra support to the promise to keep rates low and may -- it may help encourage risk-taking. It's a work in progress, though, and I think most people would, I think, agree that after all the Federal Reserve's done over the last couple years, we're not really sure in any way, shape or form more sure of what exactly the Federal Reserve's intentions are. And that's -- importantly because monetary policy is made by a committee and it -- sometimes they make decisions that cast a pretty big tent to bring everybody inside when in fact you lose some in terms of the clarity of communications. They want to reassure us that they'll keep rates low, as long as the macroeconomy is performing at a -- at a subpar rate. They've communicated that by saying that they'll -- that there's presumption they won't change rates as long as the unemployment rate's above 6 1/2 (percent) or inflation's below 2 1/2 (percent), but then they've -- add caveat after caveat to that -- to that, talking about inflation expectations, talking about alternative measures of resource slack, and meanwhile their other policy instrument, their balance sheet, is on a different track. They haven't linked up those policy judgments.

So in terms of the strategy of monetary policy, they're going to have to sew up all these loose ends, but presumably that's Chairman Bernanke's ambition over the next year.

MALLABY: So, Lewis, this is part of a broader global discussion, right? I mean, it's not just the U.S. central bank that's in some kind of experimental superman phase, it's also Japan is being pushed that way; Britain has been there for a while; the ECB in a different form, through the OMT promise, has been providing the sugar high that makes Spanish rates look reasonable.

What do we make of all this? I mean, there was a consensus just, you know, a few years ago that central banks just target inflation. Now they're doing all manner of stuff.

ALEXANDER: Yeah, look, I think it's appropriate, and if I go back to your sort of original question to Vince, are they are adding to uncertainty or are they a plus, I come down unequivocally on the side it's a plus, and all that innovation is entirely appropriate.

It is striking in some ways, if you go back to the consensus we had around what central banks were supposed to do kind of pre-the crisis, when it was independent central banks' focus narrowing on price stability -- we've clearly moved beyond that. There's obviously the role they play in supporting financial stability, but there's also a role that they play in (extremis ?) in supporting public finance. The most important way you see that now is the role that the OMT is playing sort of in the European debate.

Obviously that evolution is controversial in and of itself, but I think it's absolutely essential. You have to kind of respond to the times. Those are all roles that central banks have traditionally played in various points in time, and I think it's broadly helpful.

There's a fascinating debate going on in Japan now about, you know, how aggressive should the ECB be in this context --

MALLABY: Yes.

ALEXANDER: -- of a loss -- sorry -- --

MALLABY: Yeah.

ALEXANDER: -- the BOJ -- how aggressive should the BOJ be in a context where you've had underperformance for a decade.

I think the direction that monetary policy is moving is absolutely the right direction. It's obviously controversial, but I think that is clearly going -- has the potential to sort of improve economic performance in Japan.

And I think obviously if this -- these policies all create other challenges, the central banks will have to manage, exit being the obvious one. I think we're closest to that debate in the U.S. and, you know, to a certain extent, you know, providing accommodation in the U.S. is -- really means pushing off exit, in some respect. And how ultimately they manage those things will be crucial decisions and crucial policies that they'll make down the road.

But think there's no question that that evolution has been positive and our kind of thinking about what the goal for central banks is has expanded tremendously since sort of where we were just a relatively short period of time --

REINHART: I actually think there's a few more questions than that, because there's a deep irony here, right, that we learned from the '70s into the '80s it's very important to make central banks independent so they can conduct monetary policy better, therefore have a commitment to low inflation. That independence, codified in the law, codified in treaties, therefore gave them the ability to do fiscal policy at a time of crisis.

Now, the obvious argument is no one else was in a position to do that fiscal policy, so we welcomed the central bank interventions. But in -- but what have we given up, therefore, and what risks do we create? A central bank that is involved in fiscal policy, that has a role in government finance, that has an outsized responsibility, relative to the '80s and '90s, for resource slack is a central bank that sounds a lot like what we had in the late '60s and the '70s. And there were some problems associated with that.

Then the next -- would say, ah, but we've learned, and therefore we can run the instrument better. I think the repetition of financial crises, the repetition of inflation crises, the repetition of exchange rate crises does not convince me that in the political economy, we really do learn. And so if you give the central more tools -- (inaudible) -- going to make mistakes.

MALLABY: I mean, in some sense, you know, having, for other reasons, spent time reading about the '70s recently, it seems to me that, you know, in the '70s you had an environment in which the White House was deliberately leaking rumors that Arthur Burns, the Fed chairman, was demanding a wage hike at a time of wage freezes, just to discredit and bully him. And that's a long way from anything anyone's contemplating here today, but on the other hand, if you look at the dialogue between the prime minister and the central bank chief in Japan, I guess it could -- the pendulum could swing back, if not to an (Exonian ?) extreme, but -- you don't --

ALEXANDER: Look, there are policy challenges and risks no matter what course you take. There's no question that the risks that -- you know, that's just laid out in terms of, like, sort of how do you manage, you know, in particular, the other side of this expanded role central banks have -- this was sort of the crucial challenge going forward. Of course, central banks are going to make mistakes, but at sort of crucial moments like you faced in Europe last summer, you know, I think the basic decision that the ECB made, which was to sort of expand its role, with the objective of meeting its legal obligation to support the euro, was absolutely the right thing to do.

Now, obviously, yes, we're going to have to manage this. But I think the question of independence -- the way it was posed, frankly, kind of pre-crisis, I never thought was exactly the right way. For example, the Fed is independent in some sense but accountable to Congress in ways that other central banks, frankly, are not.

Different example -- if you look at the ECB and ask the question, to whom is the ECB accountable in the way that the Federal Reserve is accountable to Congress, there is no answer. I would argue that that is in fact a good thing. That is in fact why I think the Fed has -- in part, why the Fed has been aggressive. I think that sense in which central banks -- yes, they have to have -- they -- having a scope of independence is important, but the notion that they are in some sense accountable to a broader process has in fact gotten you better policy.

So there are certainly risks going forward. But I think this notion that you can kind of draw this bubble around it and say the only thing these institutions are ever going to do was that notion of focus on price stability -- I think, you know, the facts on the ground have moved us beyond that.

I think the question of what is their right role on sort of the fiscal side is it's only in extremis. And you know, say, for example, you know, during World War II the Federal Reserve supported the war effort by effectively facilitating the long-run funding of what was the largest expansion of federal debt we have ever experienced and hopefully ever will experience. And I would argue that process was largely managed successfully. Now, there was a long tail to exit, right, that, you know, it took us decades to sort of unwind the consequences of those choices. But I would argue it was largely done successfully.

MALLABY: Maybe we can -- we can come back to this maybe --

REINHART: I agree it's important to fight totalitarianism. (Laughter.) But I -- but I do think that in some sense, the argument is there are governmental design failures. I'd prefer to fix the regulator. I'd prefer to give the fiscal authorities the appropriate tools so we don't give unelected officials a mixed mandate, which is a bad way of designing an institution.

REINHART: Well, but the conclusion that we must fail -- I would simply argue the history doesn't support that. We will make mistakes.

MALLABY: Before we go to members for questions, I just want to put one more question on the table for Kathy, which is that you spent a long time at Merrill Lynch, very focused on the bond market. So I wonder what you feel about Japan right now. I mean, Japan has been in this sort of magical -- not happy magical, but sad magical --

BOSTJANCIC: (Chuckles.) (Off mic.)

MALLABY: Where if you actually -- if you look at the way that government debt has exploded since 1990, and yet debt service costs have basically stayed the same because interest rates have come down so much as a result of the slump, you know, that's been a sort of -- an equilibrium where government debt, although growing, has not yet caused any reversal in the Japanese government bond market. Anyone who shorted that never made the money they expected to do.

So the question is, now we might be at an intersection point. You know, you've got a new government; they're saying, let's expand the deficit some more -- more fiscal stimulus -- and they're saying, let's have some inflation. Ordinarily, both of those things are negative for bonds. So you have this delicate, fragile equilibrium which is being shaken up by a new government in Japan. Is that scary for investors, or will it be OK?

BOSTJANCIC: Well, I think certainly if you're holding, you know, elongated maturities, you have to rethink the price at which you want to hold those, right? So if you get higher inflation expectations and higher government borrowing, you would think long-term rates would start to rise. And I think you did see that happen over the last few weeks or -- during this debate -- (inaudible). And then that -- I think that certainly could be one negative factor to come out of that.

I guess it has to be weighed, just as this discussion before, as you know, what's the pros and cons? There's always some negative offsets. But on the other hand, if inflation expectations could rise in Japan, you could start to see consumption increase and the economy do better because of that, then you would sort of take that. And then on the fiscal side, they have to actually somehow contain the spending. I mean, they have a demographic -- a real demographic problem, an issue. And you know, interestingly, some people say that's maybe a prelude or a lesson for the U.S., but in reality it may be more of a lesson for Europe. I mean, we're more flexible in terms of immigration and our demographics.

And I guess I would add a little bit on the fiscal and the monetary, just to get -- to weigh in a little bit on that, I think the -- what's going in Washington is very upsetting. It's dismaying. On the other hand, it may be part of the process of dealing with the very tough fiscal issues that for decades we haven't been able to deal with. So maybe, you know, if you're optimistic, you could say this is the start, a really tough -- but over the 10 years, perhaps we'll deal with our fiscal issues, as opposed to what you see in Japan and Europe, so --

MALLABY: Well, this discussion has been exceptional so far in that we've spent remarkably little time on the eurozone. (Laughter.) But let's get members for questions. I see one right there. Craig? Microphone? Yeah.

QUESTIONER: Craig Drill, Craig Drill Capital. If the government shut down, what do you think market reactions might be?

ALEXANDER: I don't think they're going to be --

MALLABY: Dumb silence seems to be the answer. (Laughter.)

ALEXANDER: I don't think the reaction is going to be huge, in the sense that a government shutdown is not as -- is not as anywhere near as disruptive as some of the other things we sort of deal with. So say, for -- I mean, we've thought about. So for example, like reaching, actually reaching the debt limit is a much more consequential thing economically than a government shutdown.

So my guess is, given how calm -- relatively calm markets have been through this, I -- my anticipation is that it would not be hugely volatile, if we actually got to a government shutdown.

REINHART: I mean, we shut down the government in '95 and '96. The world continued to spin on its axis. Importantly, the fiscal agent of the U.S. Treasury will still be in business, the Federal Reserve, because it's off the budget. So interest and coupon payments will be made. Certainly agree that a government shutdown is, in order of magnitude, easier to absorb than a debt ceiling event.

On the other hand, it could very well do three things. One is, it will involve more fiscal restraint than currently in most projections because there will be nonessential government workers not getting paid and the business of the government won't be ongoing.

Second, it therefore could be confidence event because there will be parks closed, there will be services no longer provided and very scary headlines and countdown clocks on cable TV. And then thirdly, it could very well be a market event to the extent that the rating agencies intrude in the decision.

We have an observation that a rating downgrade in the U.S. leads to a -- (inaudible) -- to U.S. A rating agency would probably be a -- downgrade would be a one-day event, but it would still be an event. So those all three things basically are a shock to an economy that is growing at a slow -- at a relatively slow pace coming out of last year and into this and put us at risk.

MALLABY: Kathy.

BOSTJANCIC: I was just going to actually just mention that I think the biggest risk is what it'll do to confidence and confidence in our system. So --

MALLABY: OK. Another question, right here. Henny.

QUESTIONER: Thank you. I have -- I'm Henny Sender from the Financial Times. And I write a lot about the financial markets and it's a puzzle today prices are, to some extent, artificial because of the Fed. So my question -- my two related questions for you, Vince, are how absolutely does the Fed control interest rates today? And what could be the catalyst for interest rates moving higher? Thank you.

REINHART: Well, it's a lot -- it's very similar to Sebastian's BOJ question, why are long-term yields in Japan so low? And part of the answer is it is very difficult to express a contrary view of the economy that involves shorting an asset the central bank can buy. So you could -- you could be right that the BOJ finally will generate inflation because now they have a government that directs them to do so. If, however, that involves large-scale asset purchases, you can wind up being very wrong over the next year in that investment decision.

From the federal reserve standpoint, they're doing it two ways. The one is the policy duration effect. You convince everyone you will not move your policy rate up for a very long time and that will get price into the yield curve. In fact, it should make the yield curve kinked -- that is it should be flat for as long as that commitment is outstanding and then you can have the expression of -- (inaudible) -- subsequently. But to tamp down those rates -- those longer maturity rates -- that is expanding its balance sheet at about a trillion dollars a year pace, given current plans.

Can that go on forever? That goes back to Lewis' point, what's the exit? And in some sense, I think the critical, you know, discussion is about fiscal policy. There isn't an independent monetary policy if fiscal policy's unhinged. And so if we don't get fiscal policy right, four or five years from now there will be more market pressure on the U.S. and there will be nothing but even harder decisions than we have today, making me wonder if the Federal Reserve will be asked to be part of the solution, that is we'll get more inflation.

MALLABY: More on, yeah, over there.

QUESTIONER: (Inaudible.) We've seen extraordinary short-term weakness in the yen. What are the dangers now that we get a currency war breaking out?

MALLABY: That's a good question. And also maybe I could add on that, I mean, some of the dynamic seems to be that when the U.S. embarked on an aggressive QE, the ECB expands its balance sheet, the Swiss do even more relative to GDP and the Brits are doing a lot. The Japanese kind of had to join, otherwise currency strength -- (inaudible). So there is a kind of 1930s quality to this, it's a competitive not devaluation, but competitive QE, isn't it or not?

ALEXANDER: Yeah, I actually think the risks of that aren't all that high, although it obviously is an issue. It's going to sort of come up in the G-7 context and whatnot. The analogy I would make to the 1930s is actually one of the things people kind of -- you know, one of the things that important to remember is there -- the -- what people think of as the currency wars during the 1930s was progressively going off gold.

But ultimately, when it go to the point where the U.S. actually went off gold and that was the beginning of the reflation that sort of ended the, in some sense, Great Depression. And so it wasn't -- the competition actually got you to the point where ultimately everyone reflated, which was a good thing. And to a certain extent, I would argue the Japanese have been very smart in terms of the way they framed it, right, which is they have not framed it in terms of the currencies, they've framed it in terms of what are effectively the same monetary policy objectives that the Fed, the Bank of England have pursued.

And therefore, they have, you know, the currency has been a consequence of their policy, but not the direct object of their policy. And I think in that context, the risks are manageable. There's no question it's going -- that issue is going up. And I -- and I think, you know, to the extent that it comes not in places like Japan but in places like Brazil and other countries that frame their policy choices more directly in terms of the exchange rate, and therefore becomes more of an agenda item, kind of in the -- in the global process, that's when I think it becomes riskier in my mind. Then you get into, you know -- (inaudible) -- controls and the whole kind of starting to go down that road.

But I think frankly, the Japanese policy changes are sensible ones, and I think in that context, it doesn't raise quite the same issue that had they framed it as we're going to drive the yen down. I think that would have been sort of more problematic.

MALLABY: You know, when the Swiss National Bank switched from inflation targeting to targeting the exchange rate, they went around -- they called the U.S. Treasury and so forth, and said, look, we need to do this because our exchange rate is so fundamentally away from where it ought to be, and their charts showed how their misvaluation was way in excess of Japan's. Why? Because they knew that the response from the G-7 would be that if Switzerland sets a precedent that Japan can then follow with explicit currency manipulation, that is not something the G-7 wants to tolerate.

And so within the minds -- so you wonder slightly with the Japanese, whether what they're doing is cleverly clever politics. You know, they say it's all about domestic reflation; in actual fact, the exchange rate -- it's done with the exchange rate very much in mind.

ALEXANDER: Oh, I think that's absolutely right.

MALLABY: -- and so in that case, wouldn't the rest of the G-7 say excuse me, this is --

ALEXANDER: Well, but, you know, the objective of G-7 policy with respect to Japan for 20 years has been reflation, right? But everybody has pointed to that problem that, you know, they've been running deflation; they've had deflation for two decades effectively, and that that is a problem. So a policy which is directly aimed at that, I think it's very hard for people on the other side of the G-7 to take a step back and say you shouldn't do that.

Now, there is a consequence on exchange rates, and obviously, coming in an environment where the U.S. is doing a little better, Europe is doing a little better, it kind of feels -- it doesn't feel quite so problematic.

Frankly, from the European perspective, it seems to me, the Europeans are kind of schizophrenic when it comes to the euro. You know, on the one hand, frankly, a weaker euro would help them tremendously in their adjustment. On the other hand, they sort of see it as sort of an indication of successive -- you know, the risks associated with a project. And so it doesn't quite -- you know, the fact that the yen is falling is not the threat to them that you think it might be.

REINHART: So --

ALEXANDER: I -- yeah.

REINHART: So one way to put it is, look, this is a great experiment in monetary economics. We've had a central bank that for two decades has said it wants to generate inflation, now has a government that appears willing to tolerate the currency depreciation to make that possible. So will it make a difference?

And the -- and the key issue is will the government be willing to tolerate that depreciation, particularly if there are external pressures, and that is an open question. And we shouldn't forget that there have been failed prior attempts by the Japanese to reflate. And so it seems they're doing it with more force, but, you know, the verdict's still out.

I would -- the key point you make is, look, quantitative easing is an invitation to your trading partners. It is either share our weakness by tolerating appreciation of your currency or join by making your own central bank's balance sheet bigger. The BOJ is apparently joining.

It is, however, important to remember about the 1930s -- and maybe I'll try to work Hitler into this, too -- (laughter) -- in my case too -- is that in every year but one, the dollar went up in real terms because moving off the gold was asynchronous in time and in amount. And the few countries that had floating exchange rates actually depreciated relative to the dollar. So we are in the process of a global reflation, as there is -- there is uncoordinated QE, but uncoordinated QE has some of those features of the '30s. That is, it's a much bumpier road than it could otherwise be.

MALLABY: Another one. Let's go on the aisle.

QUESTIONER: (Laughs.) Thank you. Joe Bartlett, Sullivan & Worcester. Have any of you paid attention to a potential -- and "potential," quote, unquote, change in the U.S. economy which is a result, in part, of the Jobs Act and in part of the migration of financing of early stage entrepreneurial companies online versus the old road show and the potential that we -- that that would be -- potential, again -- an enormous expansion -- the early stage entrepreneurial, high-tech economy?

MALLABY: New ways of raising capital for business? Does this factor into your view? I have a broader version of the same question, but go for it, yeah.

ALEXANDER: I have to -- honestly, I have to say no, but let me put it in a somewhat broader context in saying, one of the things that has clearly kind of held the economy back is the fact that the financial system obviously had a big shock in 2008. It is adjusting to that, and part of the process of getting back to normal will be coming to some new equilibrium in the financing system where we can -- that is no longer a constraint. To the extent that that is -- that that ultimate adjustment has new channels of intermediation, that is a step in the direction of getting back to normal.

I mean, I think the broader question of, how far are we along in that process is a, sort of a very material one. I mean, Vince talked about the -- sort of, the constraints that come after a financial crisis. Those don't last forever, but the question of where are we in that adjustment is crucial, and this may be one, sort of, aspect of that adjustment.

MALLABY: Maybe I can ask Kathy -- you want to comment anyway -- but it does strike me that this raises a question for your former company. So you know, if Merrill Lynch's strength was a massive retail operation, is that being disintermediated by ways of -- you know, savers meeting consumers of capital -- users of capital through online connection, and does that change the nature of financial plans; maybe your professional history might give you something to stand on.

BOSTJANCIC: Right. Well, you know, it's sort of tougher to -- I think -- to say for sure. I would think, to some degree, that may be supplementing or more closely related to the venture capitalist system than, you know, underwriting that you would see at the investment banks and that type of funding.

But I would agree that if you're seeing credit flows and credit lending -- if that's starting to pick up and it's in an innovative way, that could be, certainly a plus. And that -- I think the other thing to think about is innovation in general, that we want innovation, we want, you know, creativity, and that's ultimately how the economy will start to grow again. I mean, housing will take us so far -- that's a cyclical response -- but underlying the economy is productivity and innovation. So that could be a spigot and something opening that we can't really quite foresee what impact that -- those type of things will ultimately have. So -- (inaudible).

MALLABY: Robert Gordon of Northwestern University put out a controversial paper saying innovation ain't what you think it is. It's -- you know, if you had to choose between the iPad and the flush toilet, the flush toilet's more important. (Laughter.) So all this new stuff is, frankly, inconsequential. I mean, do you -- do you share that kind of pessimistic that the growth -- (inaudible) -- from innovation is actually going to be less than people hope?

BOSTJANCIC: I tend to be the optimist at The Conference Board -- and I'm labeled the American economist -- (laughter) -- so my boss, Bart Van Ark, is chief economist, and he's European; he tends to have a little bit of a different perspective. But he's actually done tremendous work in productivity, and he's concerned. I kind of push back on that a little bit, but he is -- he is concerned because of the underinvestment we've seen.

If you look at -- you know, the investment as a share of GDP, and in particular, if you look at it -- how much cash is on corporate balance sheets -- as you mentioned earlier, Sebastian, there's really been a tremendous underinvestment. There's been this hoarding of cash -- for various reasons -- we can understand why -- and then long-term, what does that do to our capital stock and investment in the U.S.?

I understand that, and I think that's a risk, but I guess I'm -- also there's -- there is some -- (inaudible) -- even in health care that we're seeing emerge. And I think that we are quite flexible, and we still have potential to breed innovation. So in that sense, I seem to be more of an optimist.

MALLABY: Do you want to -- anybody?

MR. : I totally disagree with kind of Gordon's interpretation. I find it sort of extraordinary when kind of we deal in our lives every day with these advances in information technology. I -- it's sort of silly, but I spend a lot more time on my iPad than I do in the bathroom and -- (laughter) --

MALLABY: There's an overlap in your Venn Diagram. (Laughter.)

MR. : There's a -- there's a fundamental question of how we -- how we measure the contributions that come from the quality that I think of an important issue here.

One of my favorite pieces of economic research was a study that was done from the fact that after World War II, the Finns were a force to accept exports of Soviet cars to Finland. And there was, in fact, a free market for Soviet-made cars in Finland for -- from basically the end of World War II until the Iron Curtain came to be, until the Soviet Union blew up in sort of the 1990s.

What that allowed you to do was have a truly -- a true measure of what a constant -- the price of a constant-quality car was. (Laughter.) There was this fundamental problem we had in measuring output, which is the contribution of technological change to the value of the things we consume. As a matter of how we measure the statistics, it's a hard thing to take into account the fact that, like, you know, the Camry, the -- you know, the 2013 Camry is very different from the 2005 Camry, and how do you take that into account? This study allows you to do it.

And the bottom line was, it -- basically what it said was, we are dramatically underestimatinh the contributity (ph) of quality growth to actually what's going on in our lives. To a certain extent, the -- Gordon's results, I think, just don't -- you know, are -- sort of don't take that into account.

And these are hard measurement issues, but ultimately, you -- it comes down to questions like, if you think about Facebook and Twitter, there are things that frankly 15 years ago, nobody had any clue about, right? I mean, nobody -- they were -- you know, they didn't exist. Nobody could imagine them existing. And at one level, as an older person who don't really use those things, I can look at them and go, no contribution to social utility at all, right? (Laughter.) But that obviously just -- to assert it that way is obviously kind of crazy, given that people use it. And so I just find it extraordinary that we live in this world where, like, information technology, which is something we all use, is just -- is changing so profoundly all the time, to think that somehow --

MALLABY: It is possible that the use of Angry Birds and Facebook is not productivity-enhancing but --

Vincent, did you want to -- (inaudible).

REINHART: So I think the general point is we shouldn't undercount the resilience of a market economy. The way you started out, the financial industry is changing. Innovation is disintermediating some of the products they provide. The government of the United States has told us that the large financial institutions should get smaller, and in a variety of ways. And the business model of many clients is different in a world in which -- there's some element of financial repression and low rates of return.

But we'll adjust. And one way we'll adjust, probably given the -- finance is more complicated, is actually an enhanced importance of a retail network because people are going to need more help in terms of understanding financial decisions. But if we're talking about innovations, we also want to remember that we are extremely good at extracting a form of energy in the middle portion of our continent that we don't like to ship, and that will give manufacturing in our (three ?) countries a comparative advantage and will require an infrastructure buildout, to ship, to extract, to take advantage in manufacturing. And so while you can pick apart each innovation, the main thing is there's a lot of stuff bubbling up.

MALLABY: There's another one. Yeah, let's go here. (Inaudible.)

QUESTIONER: Joe -- excuse me, Joseph Kerry (sp). To follow up on your last point, the role of energy as you're looking at the economic growth in the U.S., the reports that in about 10 years the U.S. will be a net exporter of energy, how does that figure into your thinking in terms of how the U.S. economy grows over the next, say, three to five years?

MALLABY: Maybe we could put this to Kathy, and with sort of one added thing, which is that I've heard it said that the energy-intensive manufacturing sector is actually relatively nontraded, right? So you could bring down energy input costs, but if the stuff isn't traded, not that much extra production would move to the U.S. Do you think that's right or how much -- basically, the question is how much -- I mean, obviously, cheap energy is good. But how much of a real stimulus to additional manufacturing output do we get out of that?

BOSTJANCIC: That's a great question. I'm not sure I know the answer to that in terms of the energy use. I think the one think the manufacturing sector has benefited from is increase in productivity and lower unit labor costs. So our workforce is much more competitive than it was a decade ago. So I think that's been a major boost. And I'm not sure how easy it is for companies to -- (inaudible) -- tradable goods.

But in terms of energy, you know, lower costs, certainly that's a benefit. And then if we can add that to our export basket of goods, that also directly helps the economy. So I think it's a positive. Not something in the -- as you -- I think you were saying, the three to five years -- but it's not going to help necessarily in the immediate term, but I think it's certainly something that could really be very big for the U.S. economy.

And it's just an example of that innovation and things that -- you know, it's always darkest before the dawn. We're not very good at seeing what's coming down and what innovation's ahead. We've very good at saying what's wrong now and what's difficult to get through. But I think the one thing that is shown in history is the flexibility and it -- if you have the environment, these innovations just happen. And it's hard to predict, but I think that is a big, you know, game changer for the U.S.

MALLABY: They're saying that economists who look at data are not seeing into people's garages. I mean, it's in the nature of forecasting that you don't see the stuff that's being incubated.

BOSTJANCIC: Yeah, I wouldn't -- and I wouldn't and I wouldn't, you know, keep this to economists. I think it's just human psychology that we kind of focus on what's in front of us and when things are bad we all feel terrible and we'll never get out of this. But just like the fiscal mess -- I mean, maybe I'm too optimistic but -- I'm not saying we're going to -- we're going to have a lot of problems in the next year and the next couple years, but I do think that we're making some inroads and we're discussing it. At least it's on the table.

To me, what was interesting is, you know, Paul Ryan was on the ticket, you know, in the election in November. If you'd -- given his views, you know, 10 years ago, there's no way that would have happened. So it's just an example of that.

MALLABY: Another question, on the other.

QUESTIONER: Carole Brookins (sp). Is the growth trajectory we're on right now the new normal? Are we going to have a lot of people saying that -- as you said, government share of GDP has grown enormously. How much -- how likely is it to be pulled back any time soon? We've seen performance of Europe becoming more and more tepid. You know, great growth in Europe was 2 percent a year, you know, when it was really rocketing along. And you know, here we're praising the possibility of getting to 2 1/2 percent. Is this the new normal? Are we in a new structural period, at least for the intermediate future?

MALLABY: Vincent, where do you think trend growth is?

REINHART: So for now, because we're still in the shadow of a severe financial crisis, we think trends about 2 percent. We think it will be stepping up over the next five years or so because that shadow will be lightening, as the crisis recedes further into our history and we take advantage of opportunities in terms of energy extraction and get up to 2 1/2 (percent). Two and a half's better than 2 (percent), but it isn't what we did in the -- in the '50s, '60s.

And part of the story, however, is demographics. We are getting older. We -- immigration flows have flowed. Can we do better than that? Yeah, we have lots of things on the list where we can do better than that. But absent significant progress in moving out to that efficient frontier for fiscal policy, getting immigration right, getting out of the way of the resilience of a market economy, 2 (percent) to 2 1/2 (percent) is an accomplishment.

MALLABY: In the late '90s, early 2000s, when you were at the Fed, the trend growth assumption was two-point-what? The trend growth in the Fed's model?

REINHART: About 2 1/2 (percent), right?

MALLABY: Two and a half (percent)? So you're saying it can get back to where it was, so there is no structural slow down.

Yeah, OK. All right.

ALEXANDER: One of the things we economists are lousy at is forecasting productivity and particular changes in trade. We did go through a period from kind of the mid-'90s to the early 2000s when there wasn't a clear sort of acceleration of productivity growth, and you know, we're operating at a lower level. And I very much agree with Vince that the demographics are -- were kind of different, and you know, in addition to everything else, we have this benefit from basically 1970 to around 2000 of a rising participation among women that meant that the labor force was actually growing more rapidly than the -- than the population.

We're kind of on the other side of that now. And so the demographics are kind of working against us. And the upside -- the upside is, is there some acceleration of productivity growth out there; we're just lousy at actually anticipating those things. But absent that, I think we're talking about a less optimistic world.

REINHART: And don't forget the cyclical component is, as Kathy said, we are shallowing out the physical and human capital stock because there's so much resource slack. That leaves a big footprint in subsequent growth of aggregate supply.

MALLABY: We're just about out of time, but I want to just finish up by flagging two issues we haven't talked about that much. And you can just give -- you know, is it a problem or not kind of answer, each of you.

So one thing we haven't mentioned in the potential of an escalation of tension with Iran in 2013. Will that be a market-moving event, yes or no, Kathy?

BOSTJANCIC: Yes.

MALLABY: Lewis?

ALEXANDER: Don't know, but if it happened, it would be a big deal.

MALLABY: (Inaudible) -- (laughter) --

ALEXANDER: (Inaudible) -- expert on Iran.

MR. : Likely, no.

MALLABY: No -- OK, yes -- (inaudible) -- no, right? And then the second one is -- (laughter) -- you know, Spanish yields if you average across the curve around four or something, it looks OK for the moment. Big effort to keep it all quiet, at least until the September general election, but will some flare-up in Europe be an event that moves U.S. asset prices in 2013, yes or no, Vincent?

REINHART: Yes, I can't imagine that European politicians can make it a whole year without stepping on their mess.

MALLABY: Lewis?

ALEXANDER: Yes.

MALLABY: OK.

BOSTJANCIC: I would agree, yes.

MALLABY: OK, unanimity. Thank you very much for coming, bye bye. (Applause.)

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